Bedrock’s Newsletter for Friday 20th January 2023

Friday 20th January 2023

Financial markets have staged a formidable rally since the start of the year with European and emerging market equites leading the charge alongside industrial and precious metals. These assets are being buoyed by the end of ‘Zero Covid’ in China, a weaker dollar, downside inflation surprises in Europe and the US, and falling yields on bonds other than the very shortest maturity instruments. As of last night’s close (19th January), the pan-European Stoxx 600 Index was up +6.0% for the year, while the German DAX Index (+7.2%) and French CAC 40 Index (+7.4%) had done even better. Meanwhile, the Chinese Hang Seng Index was up +9.5% in its best start to any year since 1985 and the broader MSCI Emerging Market Index was up +7.5% (in USD). In commodities, metals have also surged this year, with industrial metals continuing a trend that began when protests in China in early December forced the Communist Party to end their love affair with lockdown and join the rest of the world in opening up the economy. Copper (+11.2%), zinc (+15.7%), aluminium (+8.8%), and tin (+16.0%) are all well up, while gold (+5.9%) has also registered solid gains. All of this is benefiting our portfolios, of course, and it is to be celebrated. However, we are cognisant that (as is so often the case with powerful risk-on moves) the very strength of the present rally could prove to be its undoing. As a result, we are on the lookout for a near-term correction in equities, after which we may choose to close our hedges… and just such a move may be upon us.
 
Since Wednesday’s release of disappointing US retail sales (-1.1% MoM) and US industrial production (-0.7% MoM) figures for December, markets have been swinging violently once more. To make matters worse, the volatility has been exacerbated by comments from several Fed officials that US policy rates will need to rise quite a lot more and then remain at that higher level for some time to come. The heavily inverted nature of the US yield curve suggests that investors do not believe them and instead believe that the Fed will implement a rapid reduction in rates over the coming months to cushion the economy from impending recession. Deteriorating data and rapidly falling inflation arguably support this view. But having faced a barrage of criticism for their failure to take inflation risks seriously in 2021, policymakers have no intention of projecting a dovish stance now (at least, not yet). Of course, theatre matters almost as much as reality in central banking given that credibility is vital for monetary policy to function. (Talking a big game can be just as effective as playing it!) Therefore, the market may well be right and the Fed is not unlikely to change tack quickly if a hard landing begins to look likely. But monetary policy mistakes are all too frequent – and too recent – for anyone to know for sure. In recent weeks we have gradually been increasing duration in our portfolios to lock in higher income and benefit from (what we expect to be) peak rates in the near-future. But we are careful not to put all our eggs in one basket.
 
Another clear culprit for choppy sentiment in recent days is Japan; or, more precisely, the Bank of Japan (‘BoJ’), which has so far refused to join other developed market central banks in tightening monetary policy in response to rising prices. Instead, Japanese policymakers signalled this week that there would be no change to ultra-low interest rates, and they doubled down on their controversial flagship policy of Yield Curve Control (‘YCC’), whereby the BoJ buys bonds of different maturities at whatever scale is necessary to ensure that rates (most notably the 10Y yield) remain within specific ranges and that the whole curve remains close to zero. This is despite Japanese core inflation running at 4.0% (the fastest pace in 41 years) and producer price inflation hitting a record +10.2%. In December, there was a flutter of worry that YCC would finally break, and do so in a disorderly (and perhaps even systemically risky) way, after the BoJ tweaked (i.e., expanded) the ranges within which Japanese rates are allowed to fluctuate before action is needed to bring them back to target. This was interpreted by investors as a sign of waning commitment to YCC due to the extraordinary pressure felt by the BoJ amidst soaring global inflation (and total isolation in terms of policy). Unsurprisingly, Japanese rates and the Yen surged in response. Credibility is crucial for the maintenance of YCC and projecting an unshakable commitment to ‘do whatever it takes’ to defend the policy keeps a lid on the level of purchases needed to do so. This is particularly true in the current environment where Japan’s accommodative stance is increasingly seen by investors as a daft and potentially dangerous outlier, and thus where any hint of weakness is enough to trigger the market equivalent of ‘we told you so’. With the BoJ now owning >100% of newly issued 10Y JGBs (having lent bonds to short sellers and then bought them back), as well as a sizable chunk of the local equity market, the BoJ’s approach to monetary policy is looking very bizarre. However, Japanese policymakers are in an unenviable position given that the BoJ holds a portfolio that stands to collapse in the event that rates rocket higher as they have in the rest of the world! Likely this was top of mind this week when the BoJ surprised markets (particularly FX speculators who have poured into long Yen positions in the past month) by announcing no change to ultra-easy policy despite simultaneously raising their inflation forecast. There may be no good options from here…


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